Free Financial Crisis in the US Essay Sample
The late-2000s financial crisis is the worst that has ever happened since the great recession of the 1930s. The crisis has affected all countries of the world both developed and developing alike. However, one of the worst hit countries by this recession was the United States of America. Economists argue that the economic crisis ended in July 2009 (Kolb, 2010). Others still argue that the recession is still ongoing in the U.S.A. The financial crisis in the U.S. A. can be attributed to many factors. In this paper, we will endeavor to demonstrate three key causes of financial crisis in the U.S.A. These causes include housing market, macroeconomic conditions and financial market factors (Kolb, 2010).
Financial crisis is a reduction in the economic activities which culminates to unemployment and closure of businesses as a result of lack of capital. The housing market was the greatest contributor of the United States financial crisis. Looking at the two decades from the year 1991 to 2001 the value of the houses in America had been gradually increasing. However, this trend changed drastically. For example, between the year 2004 and 2006 the ratio rose to 0.6 times and reached its peak. This increase in price of houses and mortgages discouraged people from taking second mortgages or refinancing their homes. From 2006-2008, the prices of the houses declined by 20% (Kolb, 2010).
Thinking that the house prices would appreciate, many people rushed to take ARM’S (adjustable rate mortgages). These mortgages had a less than market interest rate (Amalendu, 2011). It was not long when the mortgages were adjusted to the market interest rates. Many who had taken the mortgages were unable to pay the high monthly payments owing to the fact that their financial position could not allow them. They therefore resorted to refinance them. However, refinancing the mortgages was not easy because the prices of the houses in the United States had declined. Afterwards, defaulting of the housing mortgages became the order of the day.
The second cause under the housing market that contributed to the late-2000s US financial crisis was sub-prime lending. Many of the mortgages loan borrowers were sub-prime. The fact that the sub-prime borrowers were allowed acquire housing mortgages loan posed a great threat of having many future defaulters. However, the issue of the sub-prime borrowers was not only overlooked by the investment banks. The enterprises sponsored by the US government also allowed sub-prime borrowers to acquire mortgages. Historically, the sub-prime mortgages had been kept less than 10% up to the year 2004 (Razaee, 2011). The sub-prime mortgages then rose rapidly to 20% and by 2008 it was at 25%. This grievous mistake contributed greatly to financial crisis in the US.
The mortgage brokers likewise led to the increase in the number of defaulters. This is because of the lowered underwriting standards of mortgages. In a rush to get many clients acquiring the mortgages, they used automated loan approvals. The mortgage brokers did not keenly ascertain the credit worthiness of their clients. No wonder in 2007 almost half (40%) of the sup-prime mortgages were as a result of automatic underwriting.
The down payment of the mortgages was also lowered especially after the 2004. In 2005, there was no down payment made by 43% customers buying median mortgage houses for the first time (Razaee, 2011). This was a risky economic practice. A slight decline in price of the home makes the value of the home less valuable compared to the credit balance to clear. Consequently, there is a greater risk of defaulting and less economic incentive to stay in homes. The housing factors that caused the late 2000-financial crisis in the united states was stimulated by the new investment opportunity presented by the “housing market” due to the rising prices of houses between 2000 and 2006.
Macroeconomic economic factors also contributed to the financial crisis in the U.S.A. The changing of interest rates affected the price of assets. Normally, when the interest rate is low, the price of the asset is higher and when the interest rate is high the asset price is low (Amalendu, 2011). This is one of the reasons for the varied change of asset value of housing in U.S.A between 2000-2003 and 2004-2006. To avert the pressure of the September 11 terrorist attack, the Federal Reserve funds rate was reduced from 6.5%-1%. In 2004-2006, the federal funds rate were again increased (Kolb, 2010). As a result the adjustable rate of mortgage had to be increased which in turned led to the hiking of interest rates. Since many home owners had acquired the mortgages on account of the adjustable rate of interest, the homes became more expensive for them.
Another macro-economic reason for the financial crisis in the United States of America, just like many developed countries, was the attainment of the optimum level of technological development (Amalendu, 2011). Many countries of the world have acquired the new technologies formerly enjoyed by the United States and only other few developed countries. These technologies included manufacture of mobile phones, computers and other electronic gadgets. The financial crisis was therefore a wake- up call for United States of America to develop new technologies.
Globalization and trade deficits also contributed to the financial crisis. Competition from high exporting economies from Asian countries has posed a great challenge to the US economy. New economies such Japan and China have taken over the earlier use Export territories. Globalization as a factor has led to US current deficit which has resulted to the country importing more than it is exporting. The US trade deficit has increased steadily from 1.5% to 5.8% from 1996 to 2004 respectively (Razaee, 2011). Consequently, these have forced the United States of America to borrow funds from these emerging world economic powers from Asia. As the US government borrowed these funds to finance its import, the citizens borrowed to finance the newly emerged investment opportunity, the “housing mortgages.”
Unfortunately, the investment crumbled leading to very heavy losses for the citizens of US. Other countries such as China have invented cheap rival exports which have found their way in US markets. The money obtained from exports to US by China has been ploughed back as investment to the US market. China has therefore benefited greatly from the sale of these cheap products in the United States (Razaee, 2011).
Financial Market Factors
Financial market factors contributed to the financial crisis in the US. The widely used financial models by many CDOs, rating agencies, and CDS investors have proved to be inefficient with time. A good example is the LI’s formula which was considered reliable and very predictable. This formula turned out to be unreliable after being used for sometimes by major financial organizations in the US. According to this formula there is a very big relationship between mortgage backed securities and the price CDS. Therefore one could confidently use the price of the CDS to forecast the price of the mortgage backed securities. The formula was not reliable at the end and it caused many US financial and money lending companies to crumble causing the financial crisis (Razaee, 2011).
The inaccurate credit ratings greatly fuelled the financial crisis in the US. The fact that the rating companies were paid by investment banks and investment firms selling the securities was very controversial. Cases of these security-selling firms influencing the ratings have been reported. Most of the credit rating companies reported high credit rates than the actual ratings. This acted in favor of the Mortgage backed securities thereby increasing the sales of the securities to investors escalating the housing boom. The inaccurate credit ratings is also proved by the fact that between 2000 and 2007 some homeowners who had received loans had no income documents while some had bad credit(Razaee, 2011).
Effects of the Financial Crisis in the United States of America
Spending on the houses mortgages went down. Not only did the spending in mortgages declined but also spending in household goods also reduced. This was as a result of reduction in general lending to those who needed money. The industrial production of household products also reduced due to the cutting down of spending by consumers. Thirdly, the late-2000 financial crisis in the US led to high defaulting of those who had taken mortgages loans. This was as a result of the increase in payments as the adjustable mortgage rates increased (Kolb, 2010).
The financial crisis also led to forced merger of banks with their stronger counterparts. This arose from the fact that some banks were rendered almost dysfunctional due to writing off of bad mortgages. Apart from the long term loaning, it was also very hard for banks to offer short-term goals. Many businesses were forced to close done for lack of capital (Kolb 2010). This had the effect of increasing the unemployment rate in the US adding more problems to the already existing problem of unemployment.
The late-2000 financial crisis was an avoidable mistake made by financial institutions.. For the market participants wanted to get profits without thorough scrutiny of the financial markets and developing proper policies. We overlooked the risks in our business operations and financial innovations. We must therefore unite as stakeholders in the financial market in the United States of America and in the world to avoid such crisis in future.